Guest Post: Hard Evidence: Bailed-Out Banks Take More Risk

Politicians, Treasury Secretaries, etc. would have you believe that “moral hazard” is something we should only worry about in the abstract, in the future, when they’ve moved on to another job. But now a study confirms with hard facts: moral hazard–it lives.

Researchers have asked for some time whether and how bailouts might affect banks’ risk-taking. Would they run wild, aware of the high likelihood of being bailed out again if they ran into trouble? Or would they ease off precisely because they’d now be assured of lower financing costs and long-term survival, and therefore would want to avoid doing anything that might cause regulators to take that valuable banking license away? More daring or more discipline?

Each of these camps had its underpinnings yet the question was a difficult one to study. Why? Because, generally speaking, the developed Western countries didn’t really do bank bail-outs. [Insert smirk here.]

But then came 2008 and its bailout-palooza. And so, thanks to hundreds of billions of taxpayer dollars and an alphabet-soup of bank welfare programs, this question can now benefit from the availability of real-life, empirical data. (Cloud, silver lining and all that.)

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. You may recall that this became the centerpiece of TARP once Hank Paulson decided that the money would be better spent directly buying into the banks as opposed to overpaying them for dodgy asset-backed bonds. (Mind you, other parts of TARP were spent overpaying for dodgy asset-backed bonds.)

The CPP lasted a little more than a year and invested $205 billion of taxpayer funds into various qualifying institutions. Not every bank that filled out the 2-page application was successful in gaining access. Others were approved but ultimately decided not to take the funds (probably because of the attached restrictions on pay and on paying out dividends.) In the end, 707 financial institutions received the funds.

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand.

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find?

“This pattern would be consistent with a strategy aimed at originating high-yield assets, while improving bank capitalization ratios, since the key capitalization ratios do not distinguish between prime and subprime mortgages.”

Likewise, for corporate loans

“the fraction of CPP recipients in loans to borrowers with lower credit ratings has increased after CPP compared to nonrecipients.”

Finally, not only did the CPP recipients buy more investment securities than non-bailout recipients, but also riskier ones at that!

“[T]he total weight of investment securities in bank assets increased by 5.3% after CPP relative to non-recipient banks. More importantly, the increase in the allocation to investment securities at CPP participants was primarily driven by higher allocations to riskier securities, which increased at CPP banks by 6.2% after CPP relative to nonrecipients.”

Looking specifically at CPP recipients vs. those who applied but were rejected from the program, the authors found that the average yield on the bailed-out banks portfolios increased by 9.4%!

“Overall, the analysis of banks’ investment portfolios suggests that CPP participants actively increased their risk exposure after being approved for federal capital. In particular, CPP recipients invested capital in riskier asset classes, tilted portfolios to higher-yielding securities, and engaged in more speculative trading, compared to nonrecipient banks with similar financial characteristics.”

Moving from this granular level to a bank-wide basis, the authors found that the CPP banks increased asset risk (using ROA & earnings volatility as proxies) while decreasing their leverage (perhaps because they knew that regulators would be keeping an eye on this metric in addition to the capitalization ratio.)

What does all this mean and how should this shape actions in the future?

The bail-out itself increased our chances of having the bail the banks out all over again. Moral hazard is no longer in the realm of the abstract. Further, my guess is that the bailed-out banks took on more risk so that they could earn enough to speed repayment of the aid and therefore escape the onerous strings attached. So perhaps the limits on executive compensations, dividends, etc. in a perverse way increased our chances of having to bail the banks out all over again.

Finally, as the data on the mortgages show, banks are very good at gaming the system to make the figures work in their favor. How on earth do we get around this? Capital requirements like those contemplated for SiFis now seem to me grossly inadequate. Perhaps the answer is a Tobin tax that would force banks to pre-fund their eventual bailouts. And I say eventual because I don’t believe for a second that Dodd-Frank will do anything to enable wind-downs–when the next crisis comes the TBTFs will likely be bailed out. And we can start the whole messy process all over again.

They are all buying each other's garbage to keep the prices from collapsing. All balance sheets are a joke at this point. This is CDS-2 in action. If you can't use your original CDS insurance, then just get some cash from Ben and buy the trash.

The only solution has always been to break up big banks into many small banks, then put a cap (so un-American I realize) on how big, in % of total deposits, any institution can become. Don't tell Romney, though...he'd have you brought up on murder charges for killing a person!

"Overall, the analysis of banks’ investment portfolios suggests that CPP participants actively increased their risk exposure after being approved for federal capital."

Well duh! If you walked into a casino and were presented 2 games. Game 1 is 2 to1 odds, game 2 is 20 to 1. If its your money you'd pick game 1 (better chance of winning). Banksters always pick game 2 because you pay for the losses. Posted this video in the blackrock thread explaining how limited liability and tax incentives created these volitiliy seeking 40 to 1 leveraged too big to fail parasites.

You follow the node in the financial network.. Each crisis was absorbed by bigger nodes, until it reached Central Banks, the IMF implodes, and the institutions of the Bretton Wood system (IMF, World Bank, WTO flexible, exchange rates) are gone.

Obviously, you trade risk, instead. There is plenty of that available these days. You can just as readily skim some profits from those trades as you did when there was wealth to trade.

"Liquidity" aids this process. Since fiat liquidity is worthless, being completely unbacked by any real wealth and given to you by the government via ZIRP, exchanging it for risk is a fair trade for both sides.

Picture a bunch of prop desk guys standing in an empty olympic size swimming pool, holding a cup of risk. As they fill their cup by dealing in new securities designed to transfer risk, they get nervous and dump the risk into the pool. The cup is then empty, and they breathe a sigh of relief. Everybody else is doing the same. This process repeats itself over and over agan, and after a while, they all look around and find that they are all up to their necks in risk. That is where we are today.

But if somebody else can be found to bail out the pool and take some of that risk, its back to business as usual, since their is no wealth to trade, only risk.

Any one that buys a bank for more than a 2 hour trade is in a delusional state of mind. That makes 0 sense. No, I do not short them but never, ever trade them. Broken, lying, insolvent squids, all of them. And when I think of Mozillo I always get sick.

And look at our miners. DOW down 260 and most are green, we will not see Robot today. Maybe we break 1,800 later???

I know what you are saying. However, "designed" to collapse? What I was implying was (after the crash) reinstate GS and lets see if it works now, like it did up until the repeal in 1999. It would kill the squids.

so science is catching up with common sense....nice work if you can get it...i suppose that these astute researchers will study the effects of prunes upon defecation and announce that there is a positive correlation....

I don't see a down side to being a bank or increasing risk. In fact the only survival strategy is to become bigger and more irresponsible in order to get those bailouts and political protection.

Has any of these TBTF banks been hurt in all these years? No. They prosper on the misery they cause. They do it because they find joy in apprehending the World.

What happened to the whole 'Greek bond haircut' concept. Gone. Overnight, with the G-pap smoke and mirrors show.

You would be out on the street if you made bad decisions on risk. Until one of these banks gets nationalized, its rank and file employees put in bread lines, the executives and directors publicly linked and identified and cut down like pigs in the street, the sovereign bonds surrendered back to the issuing countries and all the "debt" cancelled - nothing will change.

If you make it to 2012. Remember this what youre seeing is the planting of demolition charges, theyre almost done....Id suggest moving away from the blast zone because the count down has already started.